Chapter Five

Depreciation and Equipment replacement

Depreciation methods
Introductory points
Asset: property that is acquired and exploited for monetary
gain such as machines, vehicles, office building, planes,
ships, boats, computers, etc.
First Cost of an Asset: total expenditure required to place an
asset in operating condition. E.g. If an asset is purchased,
it includes the purchase price related and all incidental
expenses such as transportation, tax, telephone, assembly,
expert advice, etc.
.
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 Cont.
Depreciation is a book method (noncash) to
represent the reduction/decrease in value of a
tangible asset. The method used to depreciate an
asset is a way to account for the decreasing value of
the asset to the owner and to represent the
diminishing value (amount) of the capital funds
invested in it.
 The annual depreciation amount is not an actual
cash flow , nor does it necessarily reflect the actual
usage pattern of the asset during ownership.

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 Cont.
Two types: book depreciation and tax depreciation
 Book depreciation: used for internal accounting to track
value of assets
Tax depreciation: used to determine taxes due based on
tax laws

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 Cont’d…
Depreciation is treated as a revenue loss which is recorded when
expired utility like fixed assets such as plant and machinery,
building and equipment etc.
Depreciation: the decline in the value of the asset. As time
elapses, every asset undergoes a progressive loss of value resulting
from:
1)Physical factors: wear and tear, exposure to elements
2)Functional factors: technological change
Amortization: The term Amortization is applied in the case of
intangible assets such as patents, copyrights, goodwill, trade marks
etc.,
Amortization is used to measure the reduction in value of
intangible assets.

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 Cont’d
Book Value: represents the remaining, undepreciated
investment after the total amount of depreciation
charges to date have been removed.
E.g. if the first cost of an asset is $20,000 and the
depreciation charges to date total $14,000 the current
book value is $6,000
Salvage Value or Residual Value: the price at which a
fixed asset is expected to be sold at the end of its useful
life.

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Common Depreciation Terms
First cost P or unadjusted basis B: Total installed cost of asset
Book value BVt: Remaining undepreciated capital investment in year
t
Recovery period n: Depreciable life of asset in years
Market value MV: Amount realizable if asset were sold on open
market
Salvage value S: Estimated trade-in or MV at end of asset’s useful
life
Depreciation rate dt: Fraction of first cost or basis removed each
year t
Personal property: Possessions of company used to conduct
business
Real property: Real estate and all improvements (land is not
depreciable)
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Half-year convention: Assumes 5-6
assets are placed in service in
Straight Line Depreciation
Book value decreases linearly with time

B
Dt = n- S Where: Dt = annual depreciation charge
t = year
B = first cost or unadjusted basis
S = salvage value
n = recovery period

BVt = B - tDt Where: BVt = book value after t

years

SL depreciation rate is constant for each year: d = dt

= 1/n
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Example: SL Depreciation
An argon gas processor has a first cost of $20,000 with
a $5,000 salvage value after 5 years. Find (a) D3 and
(b) BV3 for year three. (c) Plot book value vs. time.

Solution: (a ) D3 = (B – S)/n
= (20,000 – 5,000)/5
(c) Plot BV vs. time
= $3,000
BVt
20,000
(b) BV3 = B – tDt
= 20,000 – 3(3,000) 11,000
= $11,000 5,000

0 3 5 Year, t
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 Declining Balance (DB) and
Double Declining Balance (DDB) Depreciation
Determined by multiplying BV at beginning of year by fixed percentage d

Max rate for d is twice straight line rate, i.e., d ≤ 2/n

Cannot depreciate below salvage value
Depreciation for year t is obtained by either relation:
Dt = dB(1 – d)t-1 = dBVt-1
Where: Dt = depreciation for year t
d = uniform depreciation rate (2/n for DDB)
B = first cost or unadjusted basis
BVt -1 = book value at end of previous year
Book value for year t is given by:
BVt = B(1 – d)t
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Example: Double Declining Balance
A depreciable construction truck has a first cost of $20,000
with a $4,000 salvage value after 5 years. Find the (a)
depreciation, and (b) book value after 3 years using DDB
depreciation.
Solution: (a) d = 2/n = 2/5 = 0.4
D3 = dB(1 – d)t-1
= 0.4(20,000)(1 – 0.40)3-1
= $2880

(b) BV3 = B(1 – d)t

= 20,000(1 – 0.4)3
= $4320

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Unit-of-Production (UOP) Depreciation
 Depreciation based on usage of equipment, not time
 Depreciation for year t obtained by relation

actual usage for year t

Dt = (B – S)
expected total lifetime usage

Example: A new mixer is expected to process 4 million m3

of concrete over 10-year life time. Determine depreciation
for year 1 when 400,000 m3 is processed. Cost of mixer
was $175,000 with no salvage expected.
400,000
Solution: D1 = (175,000 – 0) = $17,500
4,000,000
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Depletion Methods
Depletion: book (noncash) method to represent
decreasing value of natural resources
 Two methods: cost depletion (CD) and percentage depletion
(PD)
Cost depletion: Based on level of activity to remove a natural resource
 Calculation: Multiply factor CDt by amount of resource removed
Where: CDt = first cost / resource capacity
 Total cost depletion can not exceed first cost of the resource

Percentage depletion: Based on gross income (GI) from resource

 Calculation: Multiply GI by standardized rate (%) from table
 Annual depletion can not exceed 50% of company’s taxable income.

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 Cont’d…
The annual percentage depletion rates for some common natural
deposits are listed below per U.S. tax law.

Deposit Percentage of Gross Income,

PD
Sulfur, uranium, lead, nickel, zinc, and some other ores 22
and minerals

Gold, silver, copper, iron ore, and some oil shale 15

Oil and natural gas wells (varies) 15-22
Coal, lignite, sodium chloride 10
Gravel, sand, peat, some stones 5
Most other minerals, metallic ores 14

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 Example: Cost and Percentage Depletion
A mine purchased for $3.5 million has a total expected yield of one million
ounces of silver. Determine the depletion charge in year 4 when 300,000
ounces are mined and sold for $30 per ounce using (a) cost depletion, and
(b) percentage depletion. (c) Which is larger for year 4?

Solution: Let depletion amounts equal CDA4 and PDA4

a) Factor, CD4 = 3,500,000/ 1,000,000 = $3.50 per ounce
CDA4 = 3.50(300,000) = $1,050,000
(b) Percentage depletion rate for silver mines is 0.15
PDA4 =percentage depletion rate(PD) × Gross income from
property (GIt)= (0.15)(300,000)(30) = $1,350,000

(c) Claim percentage depletion amount provided it is ≤ 50% of

the company’s taxable income.
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Equipment Replacement/Retention Decisions
One of the most common and important issues in industrial practice is that
of replacement or retention of an asset, process, or system that is currently
installed. This differs from previous situations where all the alternatives were
new.
The fundamental question answered by a replacement study (also called a
replacement/retention study) about a currently installed system is, Should it
be replaced now or later ? When an asset is currently in use and its function
is needed in the future, it will be replaced at some time. In reality, a
replacement study answers the question of when, not if, to replace.
Replacement study is usually designed to first make the economic
decision to retain or replace now . If the decision is to replace, the study is
complete. If the decision is to retain, the cost estimates and decision can be
revisited each year to ensure that the decision to retain is still economically
correct. Therefore this part explains how to perform the initial-year and
follow-on year replacement studies.
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Equipment Replacement/Retention Decisions

Reasons for replacement study

1. Reduced performance
2. Altered requirements
3. Obsolescence
Terminology
Defender – Currently installed asset
Challenger – Potential replacement for defender
Market value (MV) – Value of defender if sold in open market
Economic service life – No. of years at which lowest AW of cost occurs
Defender first cost – MV of defender; used as its first cost (P) in analysis
Challenger first cost – Capital to recover for challenger (usually its P value)
Sunk cost – Prior expenditure not recoverable from challenger cost
Nonowner’s viewpoint – Outsider’s (consultant’s) viewpoint for objectivity
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Example: Replacement Basics
An asset purchased 2 years ago for $40,000 is harder to maintain
than expected. It can be sold now for $12,000 or kept for a maximum
of 2 more years, in which case its operating cost will be $20,000 each
year, with a salvage value of $9,000 two years from now. A suitable
challenger will have a first cost of $60,000 with an annual operating
cost of $4,100 per year and a salvage value of $15,000 after 5 years.
Determine the values of P, A, n, and S for the defender and
challenger for an AW analysis.
Solution:

Defender: P = $-12,000; A = $-20,000; n = 2; S = $9,000

Challenger: P = $-60,000; A = $-4,100; n = 5; S = $15,000

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Overview of a Replacement Study
 Replacement studies are applications of the AW method
 Study periods (planning horizons) are either specified or
unlimited
 Assumptions for unlimited study period:
1. Services provided for indefinite future
2. Challenger is best available now and for future, and will be repeated
in future life cycles
3. Cost estimates for each life cycle for defender and challenger
remain the same
 If study period is specified, assumptions do not hold
 Replacement study procedures differ for the two cases

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Economic Service Life
Economic service life (ESL) refers to the asset retention time (K) that yields its lowest
equivalent AW.
The economic service life (ESL) is the number of years K at which the equivalent
uniform annual worth (AW) of costs is the minimum, considering the most current cost
estimates over all possible years that the asset may provide a needed service.

Determined by calculating AW for 1, 2, 3,…K years

General equation is:
Total AW = capital recovery – AW of annual operating costs
= CR – AW of AOC
OR

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 Example: Economic Service Life
Determine the ESL of an asset which has the costs shown below. Let i = 10%
Year Cost,$/year Salvage value,$
0 - 20,000 -
1 -5,000 10,000
2 -6,500 8,000
3 - 9,000 5,000
4 -11,000 5,000
5 -15,000 3,000
Solution:
AW1 = - 20,000(A/P,10%,1) – 5000(P/F,10%,1)(A/P,10%,1) + 10,000(A/F,10%,1) = $ -17,000
AW2 = - 20,000(A/P,10%,2) – [5000(P/F,10%,1) + 6500(P/F,10%,2)](A/P,10%,2)
+ 8000(A/F,10%,2)
= $ -13,429
Similarly, AW3 = $ -13,239 AW4 = $ -12,864 AW5 = $ -13,623

Economic service life is 4 years

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Performing a Replacement Study

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 Thank you!

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